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Woe To The Euro

The euro currency has been defying gravity for years. The Teutonic North and the Club Med South of Europe were joined under one monetary policy in 1999. But there’s no common fiscal policy for the 18 members of the euro zone, and none likely. This hardly makes the euro a desirable currency.

Nevertheless, after dropping from 1.60 per U.S. dollar to 1.20 during the Great Recession, the euro rose to 1.39 in May. And that’s despite the follow-on 2011-13 recession in the euro zone. Furthermore, real GDP since then has risen at only a 0.9% annual rate, and growth was a tiny 0.2% in the first quarter this year.

It’s true that the financial crisis in the euro zone has abated since European Central Bank President Mario Draghi said in July 2012 that the central bank was “ready to do whatever it takes to preserve the euro.” But the days of euro strength may be over because of increased fears of deflation. Euro zone CPI rose a mere 0.5% in May from a year earlier. Greece, Portugal and Cyprus already suffer from deflation, and inflation rates in Ireland, Spain and Italy are near zero.

Central bankers worldwide are deeply worried that trivial inflation in the euro zone will turn into chronic deflation. That’s why they want 2% inflation as a cushion. In January IMFIMFManaging Director Christine Lagarde called deflation “the ogre that must be fought decisively.”

The ECB and other central banks fear deflation because it encourages businesses and consumers to wait for lower prices. So inventories and excess capacity mount, prices are forced down and this causes further postponements. The result is slow economic growth, suffered in Japan for 20 years.

Also, in deflation, debts rise in real terms, to the detriment of borrowers. New loans are discouraged, and bankruptcies mount. On June 5 the ECB announced steps to depress the euro, which it blames for much of the deflation threat. A robust currency depresses import prices and forces domestic competitors also to cut prices.

The ECB cut its main lending rate from 0.25% to a record low of 0.15%. It also lowered its overnight deposit rate from zero to -0.1%, so commercial banks will have to pay the ECB to keep their money there and are encouraged to lend. The central bank also announced 400 billion in cheap loans for banks later this year as long as they lend the money to the private sector.

The ECB has yet to try outright quantitative easing, but it has already done so indirectly. In late 2011 and early 2012 it lent 1 trillion to its 800 member banks with repayment terms up to an unprecedented three years. Those banks, in turn, largely used the money to buy their own sovereign issues. Spanish banks bought Spanish government bonds, Italian banks purchased Italian government bonds, etc. During those dark days, there were few other buyers. So, indirectly, the ECB bought sovereigns.

QE on the scale implemented by the Fed, the Bank of England and the Bank of Japan would be less effective in the euro zone, since financing is concentrated in the banks, which account for 70% of corporate financing. Still, the ECB could purchase securities backed by mortgages, auto loans, small-business loans, corporate debt and packages of bank loans as well as government debt.

Count on the ECB to do more to trash the euro. In portfolios we manage, we’re short the euro against the dollar. Also, the ECB is joining the Japanese and Chinese in what may be shaping up to be a global round of competitive devaluations, aimed at boosting exports in the face of weak domestic economies. The net result will be a stronger buck, which also benefits as a safe haven during global currency turmoil.

Gary Shilling is president of A. Gary Shilling & Co., author of The Age of Deleveraging: Investment Strategies For a Decade of Slow Growth and Deflation (John Wiley & Sons, 2011), and editor of Gary Shilling’s Insight.

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